Derivatives come handy for protection against price fluctuations. There are two types of derivatives – future and options. Apart from being a hedge against price fluctuations, they can be traded on exchanges such as commodities, stocks, and currency.
Future and option trading enable those, who are disinterested in the underlying asset to profit from price fluctuations. For example, you are interested in F&O trading of wheat. You aren’t interested in hoarding tonnes of grains in your garage but, are keen to benefit from price fluctuations. Then, you can buy wheat futures and options without getting the commodity delivered to you. Most participants in the F&O market are speculators, who are not quite interested in the product. This is good as it contributes to the market’s liquidity.
Future and Options
Here's what you should know about futures and options: -
Futures: A futures contract grants the buyer the right to buy a certain quantity of a commodity, and the seller to sell it at a specific price on a fixed date in future. Let’s say a farmer wants to sell his wheat crop. He would want protection against future price fluctuations. In that case, the person will take out a futures contract to sell the produce; say five quintals, at Rs 2,000 a quintal, on a certain date in future. So, the farmer will be able to sell wheat at Rs 2,000 a quintal, even if prices in the market drop to Rs 1,500! The downside is the chance of losses if rates rise to Rs 2,500. Futures are available for a wide range of assets – agricultural commodities, stocks, currency, minerals, petroleum etc.
Options: An options contract gives the buyer the right to purchase a particular asset at a fixed price on a predetermined date. However, it does not leave the buyer with an obligation to do the same. As a result, the buyer has the choice of not exercising his right to buy if prices don’t move in the way anticipated. For example, if a wheat buyer enters into an options contract to purchase 10 quintals of wheat at Rs 2,000 on a specific date, and the price moves up to Rs 2,100 on that date, the person has the choice of not buying. The only charge the buyer must pay is the premium paid to the seller of the contract.
Things You May Also Like to Know
What kinds of assets are available for F&O trading?
There are several kinds of assets available for future option trading. They include agricultural commodities, stocks, minerals, energy, coal, currency, and so on.
Where can I do futures and options trading?
That depends on the underlying asset of the futures and options. For example, if you want to trade in F&O stocks, you will have to do it on a stock exchange like the Bombay Stock Exchange or the National Stock Exchange. If you want to trade in commodities, you will have to do it on a commodities exchange like the Multi Commodity Exchange of India (MCX) or National Commodity and Derivatives Exchange Limited (NCDEX).
What is the margin?
When you trade in futures and options, you must deposit a certain amount with your broker. This is called the initial margin. This is a percentage of the value of the transactions you carry out. For example, if the initial margin is 10 percent, and the value of your transactions is Rs 5 lakh, you will need to deposit Rs 50,000 with your broker. Margins are there to protect the broker against risk of volatility. Margins vary from asset to asset, depending on volatility. Generally, margins are lower in commodity markets. Initial margins will also be lower if positions are squared off intra-day. If you carry forward positions, you’ll have higher margins.
If the price of an underlying asset reduces, the broker may ask you to deposit more additional margin money. This is called a `margin call’. The broker may sell the underlying asset without your consent if you don’t pay up the margin. So, you could land in losses if you don’t pay margin money quickly
Which involves more risk – futures or options?
Futures involve more risk than options because when you enter into a futures contract, you must carry through the contract. For example, if you agree to sell 100 shares of Company X at Rs 2,100 per share at a future date, and prices of X fall to Rs 1,900, you will have no option but to go through with the sale. Your losses will thus be (2100-1900) x 100, or Rs 20,000. On the other hand, if you enter into an options contract, there is no compulsion on your part to sell the shares. So, your losses will be restricted to the premium paid on the contract, which will be much lower.
Commodities or equity: Which should I choose?
The potential for profit is there in both kinds of derivatives. However, you must remember that commodity markets are far more volatile than share markets and are affected by a varied set of circumstances. Generally, large institutional players tend to dominate commodity markets.
What is leverage?
Leverage is the volume of transactions you can make with the margin money you have paid. Lower the initial margin, the higher the leverage. For example, if the margin money is 1 percent, by paying Rs 10,000, you can deal in transactions worth Rs 10 lakh. Larger the transactions, more the prospect of profit. However, the downside is that the risks are far higher. If your bet goes wrong, you could end up with huge losses. Leverage in commodities markets are lower; hence, the risks are higher too.
Do I have to hold futures until the maturity date?
No, that’s not required. You can actively trade futures, which means that you can sell or buy them any time before their expiry. For example, you have a futures contract to purchase the shares of Company A at Rs 500 a share on a specific date but, you discover that prices are likely to fall. You can then sell the contract before the expiry date.